How a Partnership Makes a Profit or a Loss
Financial Structure of a Partnership
A partnership is a business with several owners. Partnerships make a profit or incur a loss in the same way as other businesses, but there are some differences in the way a partnership functions that make its profits and losses different.
How Businesses and Partnerships Make Money
The term "making money" to most people means making a profit. A partnership makes money like all other types of businesses, so let's talk about how a business makes money.
A business functions by spending money in order to sell products or services. A business also buys things (called "capital assets") to help make or sell these products or services. Then, at the end of a specified period of time, the expenses of the business are added together and compared with the income or revenue of the business. If the revenue exceeds the expenses, the business has a profit. If the revenue is less than the expenses, the business has a loss. No matter what type of business you're talking about, including partnerships.
How Partners Get the Money
A partnership account is created for each partner. From month to month, an amount is transferred to each partner's account. During the year, partners may take some of their money out of the partnership (assuming there is money available for them to take!), according to the terms of the partnership agreement. Each partner can take a draw (drawing money from his or her partnership account).
How Partner Distributions Are Taxed
When a business makes money, the money goes to the owners, in the form of net income. In the case of a partnership, the net income is divided between the partners each year, based on their agreed-upon percentage of ownership, as set out in the partnership agreement.
The partnership agreement should spell out each partner's distributive share of the profits or losses. After the end of the tax year, the partnership files an information return on Form 1065, showing the total net income or loss. Then each partner receives a Schedule K-1 showing his or her distributive share of this income or loss. The partner files the Schedule K-1 with the personal tax return.
Partner Taxes vs. Corporate Owner Taxes
A partnership is taxed differently from a corporation because, in a corporation, the profits are not distributed to the owners (shareholders) directly, but the owners may receive dividends. Usually, in a corporation, some of the profits are held (retained) by the business for growth. In a partnership, on the other hand, all profits are considered to be distributed to the owners, and the owners must pay income tax on those distributed earnings.
Partner Taxes vs. LLC Owner Taxes
Limited liability companies (LLC's) with more than one member are taxed like and work like partnerships, except that owner titles are different, and the documents are different. LLC owners are called members. The members get together and create an operating agreement, which serves the same purpose as a partnership agreement.
LLC members receive funds during the year in the same way as partners, and according to the terms of the operating agreement. At tax time, the multiple-member LLC files its taxes in exactly the same way as a partnership, using the same forms.
An LLC with only one member is called a single-member LLC, and it is taxed like a sole proprietorship, on Schedule C of the owner's personal tax return.